The Function Of Money--A Medium Of Exchange

February, 2009 Feature--Truth Based Logic

Money: The monetary function. Determining the value of money. Destroying its value: Who gains, who loses, in contrived inflation.

Most of the economically advanced world is in crisis. The Governments of lands associated with peoples, previously successful in achieving complex modern societies, are in virtual panic. Drastic, and sometimes absurd, measures are being taken to arrest a perception of economic disaster. Unfortunately, from any perspective based upon past human achievement, most of those Governments--as well as the Central Banks of their respective domains--have embraced Keynesian theories as an intended panacea. This virtually assures lasting damage to the material affairs of the nations involved.

We do not aspire to write a definitive piece on the subject of Keynes or the folly of trying to correct economic imbalances by running Government deficits or printing fiat money. Henry Hazlitt demolished Keynes half a century ago in his Failure Of The New Economics. Zygmond Dobbs, writing for the Veritas Foundation in two books, Keynes At Harvard & The Great Deceit, showed how British Fabian Socialist tactics & values became dominant on American campuses. We highly recommend these works for those wishing to study a notorious charlatan. Those familiar with our Conservative Debate Handbook, may also take note of the section on Keynes in Chapter 16. (Keynes, of course, was the Fabian's economic guru.) Our intention, here, will be merely to address some consequences of present applications of Keynesian theory to the supply & value of money.

The Nature & Function of Money

Despite popular superstition, there is nothing mysterious about money or its function. It is a medium of exchange: An economic resource that enables one to obtain value in one way, and use that value to a purpose different than that initially realized. It can facilitate the fulfillment of an immediate need or desire, or saving for a future need or desire, or provide a means for transferring means of fulfillment--whether present or future--to another, or many others, as in a gift, settlement, long term contract, trust or inheritance.

A deferred fulfillment may take the form of a savings of the medium of exchange--perhaps at interest--or an investment of that medium in tangible or intangible assets, from which an investor hopes to obtain use, or further profit, over time. It may simply involve purchase of a promise for some future benefit in a sum certain--as with an insurance policy or the like--payable in the circulating medium, the money being defined. To Americans, for over seven generations, that medium was the American dollar; the measure of all transactions, the value of those dollars.

The use of money permits a great simplification of the processes involved in producing and using wealth. If one must trade one's labor or creative idea directly for what one would buy, much that we take for granted, in an advanced economy, becomes impossible. It is almost the same with bartering goods; although once one passes from direct labor for all wants & desires to a barter economy, one has already adopted a defacto currency, a medium of exchange. Thus a look at economic history will reveal that "money" basically grew out of a need to find a commonly accepted commodity as a convenient medium for barter--a commodity with high recognition for intrinsic value and, if possible, one easily measured and easily subdivided--one likely to be the most acceptable to the most economic participants. Thus, in quite early times--before the start of the historic period for many peoples--the precious metals, gold in particular, found the greatest acceptance as media of exchange.

Gold is not just pretty to look at. It is compact, yet easily divided into precise measures. The supply can not be very easily increased. It generally requires considerable effort to obtain. This protects long term value, an essential ingredient to the continuity of human purpose, which has always included providing for the future--for passing on the material and spiritual achievements of each generation. The Founding Fathers of modern America recognized this significant relationship in our Federal Constitution, where in Article I, Section 10, they explicitly forbad the States from making any Thing but gold and silver coin a Tender in Payment of Debts. Indeed, to a major extent, it was to secure sound money--a dollar with consistent & predictable value--that the Constitution was adopted.

It is quite another matter with fiat money; with paper imprinted with a stated value, wholly dependent upon collective, but subjective, valuations of the moment. Here, there is no real, enduring, value; no increase in the net resources of a people, beyond what any money earned will buy at that moment; a value easily destroyed by changing valuations brought about by inflation of supply. And while an inflation in a people's supply of a commodity based money will involve an increase in production of that commodity, or of goods or services produced to obtain that commodity, moderating unwanted consequences from a sudden increase (inflation) in supply; it is not so with fiat money. There, as in America over the past four months, there need be no correlation whatsoever. Such inflation reflects only a thinly obfuscated effort to create an impression of solvency. For reasons we will address, it will compound, not alleviate, an economic downturn.

What Determines The Value Of Money

Again, there is no mystery here, although there may be a certain mystique. The value of money, as all other goods or services, depends upon laws of supply & demand. The more dollars available, at a given moment in time, the less utility to the individual dollar. Yet this does not mean an immediate price adjustment with every change in supply. There are built in factors, that make many prices slow to adjust--as discussed in Chapter 14 of the Conservative Debate Handbook. There are virtually innumerable variables, which may affect market valuations of just about anything, at any moment. A classic example of irrational over-valuation, with which most students of economics are familiar, would be the tulip bulb bubble in the Netherlands in the Seventeenth Century, where the market price of bulbs was bid to levels that had no reasonable correlation to the relative utility of any other goods or services. The converse of that phenomenon would be the collapse of produce prices in the 1930s.

Thus, even the buying power of a commodity based money may fluctuate widely, even when the supply is relatively controlled. Gold, because it is virtually indestructible, can be expected to fluctuate a bit less violently than one might expect with the relative value of an agriculturally based commodity, where long term storage might be a problem. Hence, a gold backed currency will have greater appeal to the provident, frugal and industrious, who seek a means to make predictable long term commitments, and to pass on their material achievements to their descendants. This gives gold additional value, beyond its mere appeal as a thing of beauty or adornment. This additional value, arising from its suitability as perhaps the best medium of exchange through time and space, is an example of that mystique, often present in determining monetary value. Yet understand the distinction between mystery & mystique!

Paper, fiat money--when no longer convertible on demand into an actual commodity--is far more dependent than any other on the maintenance of a monetary mystique. So long as it is perceived as being sound, it will have something analogous to the intrinsic value of commodity based money. But to be perceived as sound over an extended period, there must be a perception of a level of political responsibility in the Government, which today might better be described as "a fantasy of responsibility." The mystique with which a Government is able to surround a fiat currency may be the only thing that keeps it functional; but, even at its best, the ultimate determinants will be the level of disciplined restraint in the supply of such money, the general perception of that restraint and the duration of that favorable perception. Yet there are many other variables that will influence both the extent and velocity of change in the valuation of any form of money, fiat, convertible or pure commodity.

With respect to the monetary mystique--more important with respect to fiat money than to commodity based types--a partial, imperfect yet nevertheless instructive, analogy might be drawn to the medicine of a tribal "witch doctor" in a primitive society. The value of such medicine will likely have two principal sources or components: The application of herbs and mineral products--discovered over generations--which have true curative powers, and the psychological benefit derived from the level of tribal belief in the efficacy of the "doctor's" incantations. The herbal medicine, of course, is analogous to the underlying utility of a commodity; the incantations, to the faith in the Government's fiat. Unfortunately for any people, dependent upon fiat money, that faith is not likely to be so long-lived as the tribal faith in incantations.

Another instructive analogy, to better understand money & monetary phenomena, is to compare money to water. As water always seeks the lowest level--that closest to the earth's gravitational core--so money seeks its optimal utility. But just as water may be held back by impediments, whether dams or natural confines, so the flow of money may be restricted by psychological impediments. This parallel has long been, at least partially, recognized. Thus we have the common term "pump-priming," to analogize a Government's fiscal efforts to get money flowing in a political/economy with pouring water over a pump valve, before trying to draw water. Thus, even as communities dam water in great reservoirs, provident financial institutions maintain monetary reserves. The significant difference, however, is that while it may take a considerable force to breach the walls or embankments of a reservoir, to loose the stored water, or flood adjacent land, it takes only slight change in public perception of the intrinsic value of fiat money to destroy the value of the financial reserves of a people dependent upon such currency.

The current melt down in major economies, including the American economy, flowed largely from a gross over-extension of credit, made possible by an over-leveraging of Bank balance sheets against inadequate actual reserves. When a bank's liquid reserves are leveraged 30 times, it requires only a tiny percentage of loan defaults to create a crisis; and, given the nature of panics, it takes only a perception of crisis to freeze business activity among others, who may remain liquid--i.e., retaining adequate reserves of money to meet their current needs. A curious anomaly to the present crisis is seen in a rush into U. S. Treasury debt issues, which has reduced the interest on some current borrowings to zero. Mistrusting the solvency of private issuers in the present market, buyers are--for the moment, at least--oblivious to Federal fiscal management, more akin to that of funds managed by Bernard Madoff than to that of the "safe haven" imagined. This folly is likely to be short lived.

Ludwig von Mises, the late great exponent of the Austrian school of economics (Conservative monetary policy in a free market) suggested a possible coming disaster sequence, in making the point that economic expansion based upon an increasing dependence upon easy credit, could only be maintained by actually accelerating increases in credit. Since credit extensions have the effect of increasing the supply of money substitutes--that is the stock of things which serve a monetary purpose and function as currency--refusing to let credit contract is a most dangerous interference with the free market. (Von Mises suggestion sheds an interesting light on why former Secretary of the Treasury Paulson would have urged a 30 times leveraging of liquid bank reserves, before assuming office!)

The fact that a supposed contraction of credit, being extended by financial institutions in America in 2008, was from a situation where leading institutions were leveraged 30 times, certainly suggests that a major contraction in credit was long overdue, if long term financial health was an objective. This does not mean that it was desirable that the contraction be convulsive. But a contraction was in order. And yet it is not clear that any actually took place!!

On January 6th, The Independent Institute's Senior Fellow in Political Economy, Robert Higgs, published a commentary, "Terrible Credit Crunch Of 2008--The Greatest Hoax Of All Time," which cited the Federal Reserve's own data to show that there was no contraction in outstanding commercial bank credit in 2008; that while the general trend had been sharply higher, the middle months stood out "not by virtue of credit's frightening contraction, but only by virtue of its hitting a six-month plateau from April through September!"

Here we have startling confirmation of the incendiary scenario, which von Mises suggested for a political economy, in which economic objectives are premised upon expanding credit--an expansion of money substitutes and thus, effectively, of money, in a nation largely dependent upon fiat money for virtually every monetary purpose. But with the exception of the Higgs' commentary (link below), very few in contemporary American finance have recognized the enormity of what is going on.

Bailing Out Bubble Blowers, Bunko Artists & Parasites
Squandering Multi-Generational Achievements Of The Provident, Frugal & Industrious
[The Death Of Western Civilization?]

Increasing the supply of dollars does not increase the net wealth of Americans. It only diminishes the relative value of existing dollars as a medium of exchange. While the effect on prices may be delayed because of a host of applicable variables, the increase does have immediate effect in that it will increase the relative buying/saving/giving/planning power of those receiving the new dollars, vis-`a-vis those who do not receive any new or additional dollars. Thus, even though the transfers to financial institutions, being bailed out, or to members of the public, with income below a certain level, were financed by deficits, not by increased taxes on other people, there is still a net transfer of wealth taking place. Moreover, even in the very unlikely event that the Government or Fed actually tries to draw out some of the excess liquidity (as measured in dollars) later, this "robbing Peter to enrich Paul" will never be reversed. Consider:

Between 1907 and 2007, the effective value of the United States Dollar declined by over 97%, as measured against the gold standard of the Founding Fathers. While there were a few years when debt was actually reduced, with some of the excess liquidity removed by a reduction in the supply of dollars, the net picture--particularly from 1933 on--has been one of a permanent debasement of the dollar based assets of productive Americans--the provident, frugal and industrious, who in the face of a totalitarian edict, were even ordered to turn in their personal gold reserves to Government. Yet nothing in the 75 years, from Roosevelt to 2008, matched the monstrous flood of fiat money that has deluged the market in the last few months.

And yet, the past is instructive. While even the Keynesian prescription for deficit financing, deliberate inflation of the money supply, and a reckless extension of credit, may call for paying off some of the incurred debt in better times, that seldom actually takes place. Moreover, considering the nature of the damage being wreaked by Keynesian folly in the present initiatives, it would be impossible to reverse the ill effects, even were the Federal Government to impose huge tax increases, to sop up excess liquidity--now flowing into the market from newly created fiat dollars--in the future. Indeed, far from rectifying the monstrous injustice, currently being inflicted on the provident & productive, such tax policy would but add further insult to injury. The income being taxed would not correspond to the bailed losses, or the showered buying power, being provided to those who blew up the bubble, popped in 2008--or those being paid for merely existing. Rather such a tax policy would be but one more burden on those who did the right things; those who produced wealth, maintained savings and looked to pass on an earned bounty to their posterity. But even this does not capture the enormity of what is in progress.

Given the Socialist mindset of those now in power, such increased taxes will almost certainly include increased taxes on Capital Gains, on inheritances, on the lifetime achievements of a people, whose assets will be artificially inflated in dollar terms by the monetary inflation now in progress. Even the present 15% tax on long term Capital Gains is tantamount to a partial confiscation of Capital on assets held for any length of time--those taxes being assessed on the fiction of a constant dollar. But what will come, once the dam of illusion--the illusion that fiat dollars are by some mystique, a safe haven--breaks? Then, the vicious nature of pretending inflated prices represent gains in Capital will be fully revealed: Every contract, every policy of insurance, every evidence of saving or indebtedness, defined in a sum certain in dollars, will be compromised, reduced to ever declining value!

We are allowing theorists and mountebanks to squander the multi-generational achievements of the American people. It is almost inconceivable how few in the seats of power have even dared to challenge the process.

William Flax

*See link, below: How Capital Gains taxes--with compound dollar deterioration no greater than that between 1934 & 2009 (4.164% per annum)--destroy actual wealth in a fiat money driven economy.

[If you find any article at this Web Site, helpful, download it onto removable media-- CD or Flash Drive--for future use.]

Higgs Commentary Quoted

*Capital Gains Taxes & Fiat Money Destroy Capital

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